10 of the most profitable companies in the FTSE 350

Stockopedia's Ben Hobson names the highly profitable stocks most likely to bounce back from market dips.

Hugely profitable companies have a habit of achieving cult-like status in the stock market. Whether you count profitability as an important factor or not, it's hard to disagree with the fact that firms with seismic profits usually get a great deal of respect.

After all, it's arguable that profitable companies are those that are likely to have the best chances of protecting themselves through the economic cycle. They often have robust brands and strong customer loyalty. And they are able to operate and grow very efficiently, which means they can drive and compound shareholder returns over the long term. This is exactly the kind of investing approach you might associate with investors like Warren Buffett. 

But surprising as it may seem, the importance of profitability on stock returns over time is something that not everyone sees the same way. While profitability might appear to be a byword for quality, quantitative researchers have only recently started to get their heads around it.

Two years ago, for example, research by a team led by Cliff Asness at the hedge fund AQR Capital, looked very closely at this. They found that quality - defined as a blend of profitability, growth and safety - really did produce outperformance. High profitability, in particular, turned out to be a marker of firms that were better placed to bounce back from market dips.

So what should you look for when it comes to measuring profitability?

A profitability checklist

One of the most popular measures of profitability is to look at how much bang a company gets from the pounds it invests in itself. This is called return on capital employed - or ROCE. A high return on capital can be a signpost to stocks with strong and defensible brands and franchises that can be rolled out very profitably.

Another signpost to strong profitability is the percentage that a company keeps from selling its products after all costs have been deducted. This is known as the operating margin. High margins are often a hallmark of companies that can command high prices from their customers and have strong competitive advantages.

Competitive advantage is also something that can be examined by looking at what's known as return on equity. This is the technical term for comparing a company's net income to all the cash that investors have put into it. It’s a popular way of comparing the profitability of companies in the same sector. ROE varies from industry-to-industry, but 15% is generally thought to be desirable.

A fourth check in the hunt for profitability is a ratio called free cash flow to sales. Despite sounding complicated, this handy comparison lifts the lid on the proportion of sales revenues that actually turn into cash after everything else has been paid. Companies are sometimes criticised for producing impressive-looking accounts yet fail to generate hard cash. This cash flow ratio should help you spot them.

With these measures in mind, this week we’ve screened the FTSE 350 using some of the key hallmarks of strong and consistent profitability (sorted by ROCE). The Value Rank scores each stock from 100 (cheap) to 0 (expensive) based on a range of valuation measures.

Source: Stockopedia

On this basis, one of the most profitable companies in the market is property website Rightmove (LSE:RMV), which has produced some hugely impressive gains over many years. Other eye-catching names include the likes of Softcat (LSE:SCT), Hargreaves Lansdown (LSE:HL.), Auto Trader (LSE:AUTO) and Moneysupermarket (LSE:MONY). Watch out though - the Value Ranks for some of these stocks show that their popularity and strong price momentum have left them with potentially expensive valuations.

Another word of warning is that high profitability on its own isn't necessarily a defence against disappointment. Firms here like Plus500 (LSE:PLUS) and 888 Holdings (LSE:888), have seen their share prices fall as a result of operational issues that.  So care is still needed.

But even with the disappointments, on a one-year basis, this group of stocks held in an equally weighted portfolio would have achieved a return of nearly 12 percent - bouncing back from last year's dip and easily outperforming the wider market.

So the takeaway is that strong profitability tends to be associated with respected names in the market. While these stocks can become expensively priced, their strong competitive advantages can make them formidable businesses and very successful long-term investments.

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